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Should Small Bank Stocks Be Added to the Endangered Species List?

Small banks are increasingly being acquired or merged into larger institutions. Why is this happening, and is it really a bad thing?

Over the last 30 years, the number of independent banks in the U.S. has steadily been shrinking. That trend has accelerated since the financial crisis, particularly among small banks -- those with total assets under $10 billion.

In the segment below from the Motley Fool's Industry Focus: Financials podcast, host Gaby Lapera and bank stock expert Tim Hanson assess the state of community banks in the U.S. Where are these banks going, and why are we seeing such a rapid decline in their numbers? Is it competition? Regulations? Or perhaps the trend is being driven by the chance to improve shareholder returns? To find the answers to these questions and more, click the video below.

A transcript follows the video.

This podcast was recorded on March 14, 2016.

Gaby Lapera: You mentioned a little bit earlier that merger and acquisition activity has increased.

Tim Hanson: Mm-hmm (affirmative).

Lapera: The Fed actually released a paper on this a little while ago. Post-financial crisis, smaller banks have kind of been gobbled up by bigger banks. Do you have any insights into why that's happening, and why that's continuing?

Hanson: Yeah, the first would be regulatory costs have gone up pretty dramatically. One of the banks that I own personally, which I mentioned earlier, was called Carter Bank & Trust(NASDAQOTH:CARE). Mr. Carter continues to run Carter Bank & Trust, and he has, in his annual letters to shareholders, has various tirades that you can check out about how, specifically, the cost of regulation has gone up the past few years. Obviously, there are reasons why that cost has gone up, and it's not solely without merit. But when your fixed cost of doing business goes up, if you're a small company, the very first, logical thing to do is to sell. Try to spread that cost base, over a larger breadth of operations. That's been driving some people to sell. Additionally, as larger banks have needed more capital, particularly Tier 1 capital, the low-cost, loyal deposit bases that community banks have start to look pretty attractive.

Lapera: Mm-hmm (affirmative).

Hanson: Being able to buy those for 10, 15 cents per deposit dollar can be a pretty good deal for some of those. You've seen players like Umpqua Bank(NASDAQ:UMPQ) and some others try to go after regional rivals to make their balance sheets a little bit bigger.

Thirdly, like I said, having the scale in what has been a pretty tepid economy for the last few years, being able to be a little bit more geographically diversified so you're not quite as tied ... if you're Bank of Flint, Michigan, you're not just Bank of Flint, Michigan. Maybe you could be Bank of the Entire Upper Midwest or something. That gives you more opportunities.

Lapera: Right.

Hanson: To give more evidence of that point, a lot of recent strategy for some of these smaller banks is to just open loan production offices in larger cities. Cascade Bank(NASDAQ:CACB) which is in Bend, Oregon, has a loan production office in Portland now, and they want to open one in Sacramento. They're not going to take deposits in those markets, but they want to be able to make loans in those markets. Similarly, Suffolk Bank (NYSE:SCNB), which I mentioned earlier, has opened some loan production offices closer to New York City, where the economy is a little bit more dynamic than it is out on the east end of Long Island. I think the trend toward consolidation will continue. And that can be a good thing for investors, because generally speaking, something will get acquired at a premium to its market value.

The other idea here is that in the world of community banking, there's this still this ideal of the gentleman banker. There are no hostile takeovers in community banks. Mr. Carter, for example, will probably have to make it known that he's interested in retiring before any offers will materialize for Carter Bank & Trust. It can be a little bit slow-moving, even though that trend is certainly accelerating.

Lapera: That's really interesting. I remember reading about, I want to say it was M&T Bank (NYSE:MTB) was trying to acquire a smaller bank, I think in Maryland. It ended up being a disaster for them, it took them five years, because there was money laundering happening at that bank. The federal government was like, "You have to make sure that this doesn't happen again." The amount that they were laundering, it wasn't huge amounts. It wasn't like $50,000, it was like $10,000 or something, which I know sounds like a lot, but for banks that's not a lot of money. It's definitely an interesting proposition for larger banks.

Hanson: Certainly you want to know what you're buying.

Lapera: Yeah. That came out of the blue for them

Hanson: That's true, that's certainly. You hope internal controls at any bank are strong, because bank failures, whether they're small or big, are uncomfortable for lots of different people involved.

Lapera: Yeah.

Hanson: There are a couple hedge funds that specialize in trying to do activist campaigns against small banks. Stilwell is one, for example. They, for example, make sure that whenever they try to be hostile or activist with a small bank, that there are no large insider shareholders or community shareholders, because it's very hard to get them to vote against ... in the same way they're loyal to the deposit base, they're loyal to the bank. They spend a lot of time tactically finding votes, counting votes, figuring out how many shares they need to buy to actually exact change at an annual meeting. It is a chummy sector, which is kind of an interesting dynamic that you don't find in a lot of places in the stock market anymore.